EU’s ‘Fit of Pique’ on CDS Fuels Concerns

Speculators – not welcome. That is the message that the EU hopes to send with its looming restrictions on financial bets against the creditworthiness of its members.

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Credit default swaps, or CDS, are a kind of insurance against companies or governments failing to repay their debts. They are used both to protect lenders against such an event and to make bets on a borrower's financial health.

It is the latter that has turned CDS into a bugbear for many European politicians. They fret that unscrupulous "speculators" have exacerbated the continent's financial crisis by frequently pumping up the price of CDS on some countries' debts to unjustified levels, making them seem shakier than reality.

Studies have shown that rising CDS prices tend to lead to higher government bond yields.

As a result, the EU in March banned the buying of CDS on the sovereign bonds of member states when there is no underlying position to protect, or hedge.

The EU's restrictions will come fully into effect on November 1. The EU also banned "naked" shorting of European equities and government bonds, which is when investors sell a stock or bond that they do not actually hold or have borrowed.

Even among long-term institutional investors that rarely use CDS, there is concern that the restriction could lead to unwelcome and unintended consequences for the wider European bond market.

"It seems to be a fit of pique by eurocrats against investors who dare take a negative view of the creditworthiness of some states," observes John Beck, co-director of Franklin Templeton's international bond group.

"There is little doubt that CDS movements have from time to time amplified volatility but is it really CDS that made people wake up to the problems in the euro zone? Not at all," he says.

Investors, bankers and analysts are now trying to figure out what effect the restrictions will have in the future on the European sovereign CDS and bond markets.

Some of the impact is already becoming apparent. The net notional amount of CDS referencing western European sovereign bonds has dipped to the lowest since mid-2010, according to the Depository Trust and Clearing Company.

Although CDS volumes overall have declined, it has been particularly noticeable in Europe. Much of the decline has happened since the summer when investors belatedly started to react to the incoming restrictions, according to Saul Doctor, a credit strategist at JPMorgan.

"The ban has been coming for a while but the peak of investor concern was around August this year," he says. "We've definitely seen less liquidity in the CDS market, as investors look for alternative ways to go short or hedge."

The prices of European CDS have also tumbled since the summer. It is unclear how much of this is due to the unwinding of uncovered positions, rather than the brighter outlook sparked by the European Central Bank's promise to intervene, but the EU regulations has at least been a contributory factor, analysts say.

Michael Hampden-Turner of Citigroup highlights how the price of German CDS has plunged from over 100 basis points in early June to just 27 basis points this week, according to Markit.

Over that period, German Bund yields have actually climbed. France's CDS prices have more than halved just this autumn.

"The market has clearly been skewed by the unwinding of all these CDS," Mr. Hampden-Turner says. This, as far as European policy makers are concerned, would be a welcome side-effect of their campaign against speculators. But it may not last for long.

The bulk of CDS activity is done by banks and institutional investors seeking to protect underlying positions, not hedge funds looking to profit from Europe's distress.

Although these investors will still be able to buy CDS – provided this is "proportional" and has a "meaningful correlation" to their holdings – the EU restrictions will hamper liquidity in the CDS market.

This may make it harder for longer term investors to hedge in the future, analysts argue.

The EU restrictions may curb CDS activity but they do not prevent conventional short selling, or shorting through bond futures, for example.

The new rule book may lead to negative unintended consequences elsewhere. CDS activity is likely to simply migrate from government bonds to government- guaranteed or linked bonds.

While the CDS market in many of these entities is either limp or non-existent, it could pick up swiftly as determined investors seek a way to circumvent the new EU rules. Most likely, however, bearish investors may simply decide to buy the CDS of European banks, whose fates are inextricably tied to their domestic governments.

So far, there has been little "substitution" effect but investors say banks are likely to serve as the best proxy for short-hungry hedge funds in the future.

The overall consequences of the EU's CDS restrictions could still prove "quite limited", says Raymond Sagayam, manager of Pictet's Total Return Fund.

He points out that even his hedge fund was already overwhelmingly compliant with the new regulations.

But the acid test will be a renewed deepening of the euro zone crisis, he warns. "Until we get another bout of turmoil, we won't know the full impact of all this."